An Economy Dependent Upon Easy Credit

March, 2009 Feature--Truth Based Logic

America's addiction to easy credit. Like most addictions, progressive. The saving/borrowing ratio & an alternative to chaos. No easy, no perfect answer; but rehabilitation preferable to death.

What stands out most clearly, amidst all the panic inducing talk and extravagant promises, lately spewing from the mouths of Federal office holders & Central Bankers, is of a desperate need to keep America dependent upon credit--easy credit;--that what is most feared, in the seats of economic power in contemporary America, is a period in which people restrain expenditures for new goods and services, pay down debt and actually try to provide for the cyclical, as well as disaster driven, downturns that have always been part of the economic history of human nations.

To the sound money Conservative, this brings to mind the sixty year warning from the great Austrian exponent of market economics, Ludwig von Mises, who in Human Action, addressed "Interest, Credit Expansion & The Trade Cycle:"

The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.

While it is possible that the totally irresponsible policy, which allowed banks to leverage assets thirty-fold, while not arresting a bundling of assets in vehicles for which no one can calculate even a good theory of actual value--in order to have banks effectively subsidize home ownership for the beneficiaries of political favoritism--may already have led to the "crack-up boom and breakdown." That is not certain. What does appear to be, is that the present monetary authorities in the United States will never desist until such a crack-up and breakdown are impossible to arrest.

Last month, we cited an article by Robert Higgs, Senior Fellow in Political Economy for the Independent Institute, which used the Federal Reserve's own data to show that there was actually no contraction in outstanding commercial bank credit in 2008; that after a sharp rise, the level merely hit a "six month plateau from April through September!" We all know what happened in September; what has continued ever since. Is it still possible to avert von Mises' disaster sequence?

Since Biblical times--Genesis on--in the West, perhaps earlier in China with a more ancient history, records show that man must deal with lean years as well as good. Provident man has always sought to put aside produce from the good years for the lean. As explored last month in our exposition on money, a provident people understand that their money serves not only a function for the immediate exchange of their labor or services for the goods & services such might buy; it is the means for exchanging today's produce for an ability to meet tomorrow's needs & desires. No one with an intelligence level above the most basic can fail to understand that when the head of a household lives profligately, the family is at ever greater risk in an economic downturn. The reason that so few seem to understand that the managers of a people's money, acting profligately, are governed by the same reality, may be in a hesitation to accept the consequences of reality on so staggering a scale. Yet multiplying the family profligate, one hundred million times, does not a providence make; nor does it change the fact that macro economics are nothing more than a statistical aggregation of the effects of millions of micro economic decisions that take place every day.

This is hardly the first time in human history, where a failure to grasp obvious truth--even a deliberate rejection of that truth--has been based upon a combination of emotional recoil from a too terrible reality with the almost limitless capacity of the human proto-type for rationalization. Yet even among the most profligate, there are occasional windows of comprehension. Thus, even among some of the worst prodigals in Louis XVth's France, there were acknowledgements of "after us the deluge." Thus, in an interview recently aired on CNBC, former Federal Reserve Chairman Alan Greenspan affirmed that some of the leaders in American finance had been aware of the risks inherent in their over-leveraged practices, well before the breakdown. Yet they persisted in a greed induced folly.

What we are describing, here, is clearly an addiction--one sustained by rationalizations, just as every substance addiction is sustained;--one driven by a frenetic need, just as every substance addiction is so driven. That even a leveling off of the creation of bank credit can throw every Keynesian in the land into total panic, to such an extent that they so panic the Market as to actually freeze much of commerce--the precise opposite to a proclaimed intention--confirms von Mises' understanding of the subject. The addiction, not unlike an addiction to heroin or cocaine, is progressive.

It is further evidence of such progression, that while many, Constitutionally literate, challenged FDR's Keynesian attempts to pull America out of the last Depression; almost no one in Washington, today, will even discuss the Constitutionality of proposed measures, far more extreme--far further from a Constitutional purpose--than anything ever attempted by Roosevelt. The true addict does not scruple over legality.

Savings/Borrowing Ratios & An Alternative To Chaos

We have discussed the long recognized need to plan for lean years, as well as good. With civilization, the provident and frugal began to save produce and, with the development of money, that medium of exchange between current earnings (the fruits of labor & production) and desired usage, for future needs. As folk prospered and accumulated more for the future than the likely needs of each producer in those lean years, there developed systematized relationships between those who had such capital reserves and those who perceived a benefit in borrowing from that capital for more immediate use. While this took various forms, what concerns us in considering the addiction to easy credit in today's market, is the ratio between such surplus savings and the demand for borrowing against them, always with consideration of the reasonableness of an expectation for repayment.

First, it must be clear that without provident & frugal producers, saving for the future, there would be nothing of value to lend. Second, that so long as the producers of wealth directly controlled the lending of wealth, there was a natural tendency that loans be either fully collateralized, by pledged assets worth more than the balance on the loan, or that the lender be of sufficiently high character and personal reliability, that an expectation for repayment be eminently reasonable. In this situation, there was ordinarily a balance, one enforced by mutual self-interest, leaving little, if any, incentive to profligacy. One lending the fruits of his own labor, would not likely lend to one seen to be irresponsible. Indeed, one bad experience in any neighborhood, would put all with savings on notice to be very careful in their assessment of a potential borrower. Yet even in centuries long past, it was clear that it were wise to exercise great care on both sides of such interaction. Thus four hundred years ago, we have the sage advice in Hamlet--referring, in the story, to a time much earlier--to avoid being either a borrower or a lender. The fact is that even the best expectations on either side, like the "best laid plans of mice and men, often go awry." Yet there is little doubt but that, on balance, economic growth has been furthered through the centuries, in lands where a legal system enforced the obligation of contracts, by a process whereby prudent lenders effectively put the deferred enjoyment of the fruits of past labor to work, in extending loans to prudent borrowers.

The problem arises from multiple factors, both political and private. In trying to assess blame, we immediately stumble on a recurring enigma: To what extent does a corrupt Government, meddling in what the framers of our Federal Constitution intended to be private economic decisions--such as an expansion of bank credit--while failing to properly define the measures of commerce--as the written Constitution intended;--to what extent, do such political phenomena reflect political corruption or a moral decline in the population, at large, which undermines resistance to usurpation, even as it stirs organized demands for special favors that motivate political corruption? Consider, in the current economic malaise:

A. The recently burst housing bubble--in part prompted by political pressure to promote more home ownership; yet reflecting a previously popular urban legend that house values only move up, as well as a still growing entitlement mentality in the general public.

B. The financial bubble--the lenders' side of an addiction to ever easier credit--burst as a result of A & partly blown by the same political pressure on mortgage lenders to extend credit to those with poor prospects for repayment--often with little or no down-payment--also reflecting greed in a virtually uncontrolled managerial class, seeking to increase their scope (and bonuses) by deliberately increasing the leveraging of managed assets.

C. In blowing the bubbles described in A & B, a major factor was an innovative pursuit of (ever more difficult to measure) financial derivatives, such as bundled "sub-prime" home mortgages--an idiotic idea discussed in "Congress & The Regulation Of Commerce," linked below. By flooding financial markets with such devices, the ability of the Market to adjust to post-bubble conditions has been greatly impaired. (What this means, inter alia, is that any Depression could last even longer than that which the Keynesians prolonged, so outrageously, in the 1930s.)

In this developing mess, it is impossible to attribute blame to only one set of "players." Yet, from a larger perspective, it may be said that all reflect a moral decline--a cultural deterioration--of American Society in the broadest sense. We have ignored centuries' old wisdom, found even in our children's stories. We no longer admire the natural--God given--proclivities of the squirrel. We have embraced, instead, the impatient folly of the most foolish pig, to replace a smaller, but solid and easily maintained, house of brick with a vastly larger--for a brief, silly, moment--house of straw, which the first serious wind has now scattered all over the economic horizon. Yet rather than return, to rebuild what the credit expansion tore down, by embracing the proclivity of the more provident to increase saving & pay down debt; depraved & confused Keynesians (two different groups) have pulled out all stops to "reinflate" the Market. They are determined to try anything & everything but a return to the wise economics on which the original, sustainable, American success was built.

Fiat money does not represent real wealth. So long as it is accepted in the Market, it may provide a means to transfer, spend or save real wealth. But, as discussed in last month's feature on "Money," its value depends upon the ratio of its quantity to its total usage. The major reason prices for some goods & services have fallen, even though the Federal Reserve has pulled out the stops, radically increasing the money supply & trying to get financial institutions to further the process by increasing lending yet further, is because those Americans, who still understand why squirrels, left to their own devices, thrive, and why one builds with bricks in preference to straw, have finally started to increase savings. Allowed to play out, allowed to shift the ratio of saving to borrowing & saving to spending--the very idea of actually saving, being new to many of today's families--the process is a true start to rebuilding.

The addictive aspect of easy credit must be recognized. In this writer's lifetime, there has been an increasingly apparent cultural change in the way most major purchases are consummated. A few decades back, a new car purchaser would go to a dealer, select a model that interested him, and then discuss what sort of discount the salesman might offer from the sticker price. For some years, now, there has been much less flexibility as to price; rather the dealer has sought to direct attention to the best obtainable "monthly payment." It was not that many buyers, formerly, did not seek financing for part of the price; it is just that the whole approach has changed. What has happened in car dealerships is reflected, also, in sales of major appliances, furniture, etc.. It is no longer a question of thinking in terms of a purchase price that one can afford, but of accepting monthly payments--often deferred for months until one might hope to have a bit more to spend. To paraphrase a popular song of those earlier decades, millions & millions of American families now "owe their souls," not to the "company store," but to the finance companies.

We recognize dangers inherent in a too sudden correction of American business's over-dependence, both on obtaining credit & extending credit to promote sales. The situation is analogous to other forms of addiction. The "cold turkey" approach may work for the isolated individual, it does not succeed with most addicts. Applied to a market long fueled by an accelerating dependence upon easy credit, it could lead to financial ruin on a vast scale, possibly followed by revolution & chaos. That said, it does not mean that we do not need to address the disintegrating savings to borrowing ratios in purchases of real estate and major "consumer" goods & services. That the pattern that has developed over the past two generations must be reversed, if we are ever to return to a provident, frugal & predictable economic model, is as certain as the disaster, now unfolding, was an inevitable consequence of past folly. More to the point, chaos & revolution--the very death of the America we have known--may indeed be inevitable, if we fail to address the still present addiction to easy credit.

What is required, then, is a long term commitment to return to sound principles--a studied reduction of reliance or dependence upon easy credit. This may be no easy, no perfect answer. Yet rehabilitation is preferable to death. The methodology is not difficult to fathom. All that is needed is the will.

There is a natural attrition in the ratio of borrowing to assets as loans are paid off--at least as to the more provident, who pay their debts. So too, the converse. The lending institution's outstanding loan totals are reduced by such repayments. A policy that limits new loans from the proceeds of such payoffs to only a certain percentage, until a set target for the ratio of total loans to real assets has been achieved, properly maintained, would address the problem without adding to an immediate panic or acerbating the negative consequences of the long over-due correction. A similar policy, with respect to what percentage of new deposits might be loaned, would work to similar effect. (We realize that this is the opposite to what Keynesians seek, which should certainly recommend it. They are neither altruists nor sound economists.)

While we would not advocate a system where there could be no leveraging of assets, we would abjure the notion that double digit multiples should ever make sense to the provident or frugal. While 30 times leveraging was insane, 20 or even 10 times leveraging still denies the reality of economic history. There are always lean years. There will always be lean years. No boom can go on long enough that such folly go unrequited!

While on the subject of economic history, both as applied to easy credit and to the excessive leveraging of assets to make easy credit possible, as well as to other notions of benefit from excessive risk taking, we must address one other "urban legend," particularly pertinent to the present malaise: The myth that what the Market rewards, under a free Market system, is risk taking. One hears some cliched version of this fantasy almost daily in market commentary; yet it represents only another example of the sort of myopia that cannot grasp the fuller context of a functional dynamic. The Market does not reward the risk; it rewards the execution of a valuable project or idea. The risk in launching that valuable project, or idea, is part of the cost of production or utilization; but it is the value of the project, not the risk, that is rewarded--that, in effect, is being purchased.

Where all that is involved is risk; where the project is not sound; there is no reward. The need to take risks--and there is often a need to take risks--is never an answer to the need for provident & frugal behavior. It is by provident & frugal behavior, that we create stores of wealth--the capital resources--that enable entrepreneurs to launch the valuable new project or idea. One of the many fallacies of the Keynesians & outright Marxists, who advised the "New Deal," was in their willingness to take risks for the sake of taking risks, by innovations that anyone with a modicum of common sense should have known could only do damage; could only prevent normal Market adjustments, which would enable true healing. The current effort to relaunch a "New Deal"--yet on an even grander scale--will only do yet more damage.

William Flax

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